The Deal on VC Portfolios: the bigger the better?
When starting out as a fund investor, you are faced with the age-old question of whether to adopt a concentrated or diversified portfolio strategy. Should you bet in a smaller number of startups with larger cheque sizes or in a larger number of startups with smaller cheque sizes?
At Accelerating Asia, we have decided to build a larger portfolio. This is our reasoning.
Amplification of power law in early stage
Venture capital fund economics depend on the power law, where a small number of investments drive overall fund returns. Here are some statistics to put things in perspective:
- A Correlation Ventures study showed that ~65% of deals failed to return the investment amount
- 3 startups (Airbnb, Doordash, Stripe) represent >50% of Y Combinator’s portfolio value
- Data from Horsley Bridge, an LP across many US VC funds, showed power law in action across funds: in >5x funds, <20% of investments led to ~90% of returns. In 3x-5x funds, <10% of investments led to ~55% of returns
Correlation Ventures Study
On $300B of YCombinator Success, Jared Heyman via Medium
Horsley Bridge data, graphic from Toptal
In early stage investing, the effects of power law are amplified. Early stage is characterised by higher risk driven by higher startup death rates, along with higher returns driven by lower entry valuations. This means that a higher number of investments would likely not return, while the small number of winners provide larger returns.
Jerry Neumann aggregated some data around this which showed that smaller (and earlier stage) funds have a higher alpha value in the power law distribution formula. This means a fatter tail of failed startups and stronger power law effects: fewer but bigger winners.
More bets to find the homeruns
The significance of power law in early stage VC investing makes finding the homeruns extremely important. While due diligence and research can help VCs make educated investment decisions, we cannot hide from the fact that picking winners is hard, especially in early stage VC.
The other way to maximise the probability of investing in these large winners would be to take more bets. At Accelerating Asia, we believe that our combination of due diligence and large portfolio size strategy would enable us to build a portfolio with winners and deliver outstanding returns to our limited partners.
But what exactly is a large portfolio size? From Steve Crossan’s Monte Carlo simulations (based on summary statistics), median fund returns improved rapidly as portfolio size increases to 50 startups, with the increase slowing down as portfolio size grows further. A 2018 report by Different [source] found the median and mean VC portfolio size to be 25 and 29 startups respectively, suggesting a skew towards the large portfolio size strategy.
Median Fund Returns & Portfolio Size in Simulation via Medium
Some concentration, not just diversification
While Accelerating Asia has a large portfolio size, we do make some concentrated bets through follow-ons. While all eligible startups selected for our flagship accelerator program receive an initial US$100k cheque, we invest additional capital into a select few after the 100-day program.
Our day-to-day interactions with founders during the program act as further due diligence while the program acts to lower the risk, allowing us to make more informed concentrated bets. We invest a total of up to US250k per startup.
Beyond increasing our investment amount, we reserve a portion of our fund for follow-on investments as we exercise pro-rata rights in later rounds. This helps us ensure that we own sufficient stakes in our winners, the top performers in the portfolio that we’ve identified during the flagship accelerator as those most likely to deliver outsized returns to drive overall fund returns.
Qualitative Factors: the Accelerator Model & Ecosystem Gap
There are also other qualitative factors which support our decision in building a large portfolio. Across our previous cohorts, a common aspect founders loved about the program was the unexpected synergies that emerge between portfolio startups. We have portfolio startups building partnerships that drive up growth and idea/ resource sharing between founders. This is enhanced and made possible by our large portfolio size.
Moreover, this portfolio strategy aligns well with our strengths and how we see ourselves as part of the larger startup ecosystem. Within our geography (Southeast/ South Asia), we find a robust set of idea stage incubators and an abundance of great Series A+ VCs. We find that there is a gap for post-revenue founders who have built some traction but are facing roadblocks in scaling up to the next stage and getting ‘Series A ready’.
This ecosystem need is stage specific, and we find that it can be most effectively addressed through customised, hands-on, high value aid through the accelerator program. Beyond that, there are great VCs in the region that we can hand over our portfolio startups to for larger cheques and mentoring. This allows us to manage a larger portfolio while maximizing the scale of our impact in the ecosystem.
In short, as an accelerator, our large portfolio size adds value to startups and contributes to an increase in return opportunities for the fund.
Final thoughts
Our confidence in this strategy is bolstered by the great company we find ourselves with. Most accelerators and incubators that have done well such as Y combinator, 500 startups, and Techstars also have large portfolio sizes. Other successful angel investors also take the large portfolio size approach: Jason Calacanis, Xavier Niel, Naval Ravikant, Charlie Songhurst, Fabrice Grinda etc.